About Those Plunging Oil Prices

Over the past three weeks, there have been numerous headlines insinuating that a freefall in oil prices is underway. Last week I read that the various causes were a slowdown in China’s economy, OPEC’s decision not to cut production, and America’s growing oil production. Based on the headlines, one might suspect that we were right in the middle of a major bear market for oil.

Just how far had the price of West Texas Intermediate (WTI) fallen? All the way to $92 a barrel. Keep in mind that WTI opened 2013 at $93.14 a barrel. Since then it has traded between $98/bbl and $87/bbl. (In my Five Energy Predictions for 2013, I predicted that the price of WTI would average less this year than last year, and that the Brent-WTI differential would narrow. To date both predictions have proven to be accurate).

According to the US Energy Information Administration (EIA), the weekly average price of WTI this year traded below $90 only once. The week ending April 19th the average price was $88/bbl. Over the past 12 months, the weekly average has traded in a range of $17/bbl. The low took place during the week ending June 29, 2012 at $80.33 and the high occurred the week of Sept. 24, 2012 at $97.56. The weekly average price of WTI over the past 12 months has been $90.95. So despite the bearish headlines, WTI is still trading above the average over the past 12 months.

Over the past 2½ years, the average weekly price of WTI traded below $80/bbl only once. During the week ending Oct. 7, 2011 the weekly price averaged $79.43, but then climbed back above $100/bbl within two months. To get consecutive closes below $80/bbl, we have to go back nearly three years to the end of September 2010.

Following the oil price crash in 2008, there was some weakness in early 2009 that for a short time saw weekly averages in the $30’s and $40’s, but by October 2009 the price had once again reached $80 despite a severe economic slowdown.

Typically the cycle of oil prices goes like this. High oil prices result in increased spending on new projects by oil companies. But high prices also slow the economy, reducing demand for oil in the process. This combination causes a supply surplus that leads to plunging oil prices and lower investment in new oil projects.

This is a cycle that has been repeated many times, but I believe this cycle will ultimately come to an end because I don’t believe the oil companies will always be able to build out spare capacity to stay in front of growing demand.

Over time the lower prices brought on by the supply surplus act as a stimulus to the economy, and demand — and in turn oil prices — pick back up. Because of the underinvestment by oil companies during the period of low prices, we often see an increase in demand at a time when the oil industry isn’t increasing supply. Thus we return to the oil price spikes that slowed the economy in the first place.

But the 2008-2009 bust was unusually abbreviated. True, prices did plummet, but they didn’t stay down long. Here is why:

Historically global demand was dominated by the US, and while the US and EU both saw decreased demand as a result of the higher prices, demand in every developing region in the world continued to grow. Thus, unlike previous oil spikes, global demand continued to climb and the oil industry was unable to build out the kind of spare capacity that had taken place in the face of previous price spikes.

Between 2000 and 2011, global oil consumption increased by more than 11 million barrels per day, but the development of additional production capacity did not keep pace. This eroded spare capacity in the global oil market, which led to much higher prices and greater volatility.

A number of agencies are predicting much lower oil prices in the coming years. I have been hearing these predictions regularly since 2005. Daniel Yergin, author of the Pulitzer Prize-winning book on the oil industry called “The Prize” and one of the most highly-respected analysts in the industry, consistently underestimated the price of oil during the past decade before recently reversing direction.

But I do agree with the sentiment that supply is likely to expand for several more years. It’s just that demand is going to expand as well, and existing fields will continue to deplete. In an interview conducted last year with former Shell president John Hofmeister, he corroborated my thesis:

“In 2005 China needed about 5 million barrels per day (bpd) of oil; in 2011 China needed 10 million bpd of oil; by 2015 China will probably need 15 million bpd of oil. And that kind of tripling of demand in China, augmented by significant additional increases in daily demand from the rest of the developing world, including India and the fact that OPEC has been largely flat in its production and its inability to create spare capacity for most of the last decade is behind surging prices.”

Oil depletion reduces production in existing fields by 4 million to 5 million bpd each year, which means it takes that much new oil development just to maintain global production rates. Mr. Hofmeister summarized the problem as “We have not been able to keep up with demand growth and the decline rate simultaneously.”

However, over the past few years tremendous investments have been made in finding and developing new sources of oil, and growing demand will not as easily erode spare capacity as in recent years. This is why I have predicted that oil is likely to trade in a range — perhaps as low as $70 up to maybe $120 for the next few years. Some may feel that it is unlikely that oil could fall to $70. After all, it’s been three years since the price of WTI was at that level. But if Iran capitulates on its nuclear program, escaping the related trade sanctions, a lot of oil could hit the market, and certainly the expectations of oil traders could drive prices down in a hurry in that situation.